For most regional and community banks, the old-fashioned business of making loans remains their most important source of revenue. And for most of these banks, small businesses are a big part of their customer base. Yet they struggle to lend to small businesses profitably.
You’ve probably heard the statistics before: Small businesses represent about half of all U.S. employment and about 40 percent of private sector GDP, according to the U.S. Small Business Administration, and yet they only get around 21 percent of commercial bank credit. Nearly half of all small businesses sought some kind of loan in 2015, according to the Federal Reserve Bank of New York (the last year for which we have broad data from Fed surveys), so the demand is there. What’s going on here?
As anyone who is familiar with lending to small business can tell you, it has traditionally been extremely difficult to measure and manage small business credit risk in a cost-effective way. Current legacy methods either expose the bank to too much risk or incur so much cost that small business loans can’t be made profitably. Hence, banks are unwilling to deploy capital to small businesses on the same scale they do to consumers or large commercial entities.
The False Dichotomy of “Consumer” and “Commercial”
The difficulty that banks experience trying to make loans to small businesses is like trying to eat soup with a fork.
Let me explain.
When it comes to lending, most banks still see the world falling into one of two categories: “consumer” or “commercial.” Consumer lending is a highly-standardized process while commercial is a highly bespoke one.
The consumer process gains its efficiency by ignoring the positive attributes every small business has, such as cash flow, and primarily relies on the small business owner’s credit score to assess risk. This generally means that the lender is not getting an accurate read on capacity and risk, and therefore is very likely to either take too much risk or turn away a lot of potentially good business.
The commercial process, on the other hand, gains its reliability by taking a far more diligent approach. It requires a heavy dose of manual credit analysis done by highly trained (and well compensated) professionals. Lenders expend significant time and resources gathering information, spreading financials, reviewing collateral and analyzing many aspects of each business to a degree that a small request—say for $25,000—is treated much the same way as a larger $750,000 request.
The Right Tools for the Job
Small businesses are a different category of customer. Most have a mix of consumer and commercial attributes. To underwrite them effectively and profitably requires marrying some of the efficiency of the consumer process with some of the underwriting capabilities of the commercial process. Either one alone will fail.
If your only choice is a fork when eating soup, the experience is going to be so frustrating you’ll likely give up.
But what if you had a spoon?
Here’s what a small-business-lending spoon looks like:
First, it enables online originations to reduce the dependency on expensive bankers for small loan requests.
Second, it provides the flexibility to use better small business underwriting information such as real time operating cash flow versus dated tax statements or just the owner’s credit score. For example, reviewing the past 60-90 days of bank transactions is more indicative of the credit worthiness of a restaurant than the information in a dated document or a lagged credit bureau score.
Third, it supports automation to manage every step of the application process as well as the subsequent servicing and monitoring of the loan. As an example, bankers today will process loans sequentially without regard for incoming credit quality or loan size. How much more efficient would it be if loan requests where categorized into “likely approval,” “likely decline” and “needs review” before a banker received them? The power of a speedy decline would eliminate a significant amount of wasted time and effort.
As a former banker and experienced tech entrepreneur, I have been fortunate enough to witness and even play a role in forging some of the early “spoons” that have helped transform this market. So far, however, most of the pioneering work here has happened outside banks.
What Bank Can Do
Small business lending will not be solved by building more branches, or spending more money on training and marketing. Banks must expand their technology tool set, especially when originating small business loans.
So how does a bank introduce new technology without it costing millions of dollars and years of effort?
A bank must look to the new breed of bank-friendly technology companies for help. Many of these new fintech companies can make the process of testing and adopting new technologies remarkably easy and cost effective. Long gone are the days of long-term contracts, expensive integrations and multiyear implementations. The ability to quickly test technology and pay for rapid success is here. Banks just need to find the right partner and have the willingness to explore the possibilities.
If you are hungry for some soup and want to enjoy it, go get yourself a spoon. Stop the insanity. There are better ways to manage small business lending in a cost-effective manner, it is time to look beyond your legacy technology providers for a solution.